We all know that indexing is cheaper than active management, in which a fund manager selects specific assets for investment. But why has passive investing been so successful during the past few years? Asked differently, why has active management had such a dismal run?
Theories abound. Let’s consider each:
• Too much competition. As Charles Ellis, a former member of both the Yale endowment fund and Vanguard’s board, has noted, gifted investment professionals have flooded the market in the past 30 years, making it more difficult to capitalize on missteps at enough of a clip to beat the averages.
Hence, being smart, hardworking and savvy may create only a short-lived advantage — or none at all.
• Main Street has given up on Wall Street. The average retail investor over the past 15 years or so has endured the dot-com boom and bust, the housing bubble, a full-blown financial crisis followed by an awful stock-market crash, a whipsawing commodities market and almost zero returns on cash savings. These investors now suffer from finance fatigue and have little interest or faith in anything that Wall Street is selling.
• Stricter enforcement of insider trading laws. The Justice Department seems to have rediscovered insider trading. Why? Because it’s a) relatively simple to prosecute; b) there’s often lots of unambiguous evidence; and c) the odds of a conviction are high.
• The Internet has leveled the playing field. Much of the information that once was the province of a select few is now in the hands of all. It was a huge game-changer when Yahoo message boards began to fill up with posts from people doing legwork on individual companies. At first, few grasped the connection with investment opportunities. Now, everyone knows and the advantage has largely disappeared.
• Too much capital chasing too little alpha. According to Nobel laureate William Sharpe, there is only a finite amount of alpha, implying that trading is a zero-sum game. Thirty or so years ago, there was greater information asymmetry. When pension and endowment funds were smaller and less invested in alternatives (like hedge funds, venture capital and private equity), there was more alpha to be divvied up among fewer players.
I suspect that the changes we have witnessed are of a permanent nature — active management might again have its day in the sun, but those days will be fewer and further between.
Barry Ritholtz, a Bloomberg View columnist, is the founder of Ritholtz Wealth Management.